Sunday, June 24, 2012

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The purpose of this series is to discuss the practical lessons we can learn from behavioral economics, the branch of economics that studies how decision-making is influenced by what we feel and what we think. This is Part 3 in the series of four columns.

In Part 1, I explained that most people are poor investors because they make decisions primarily to avoid emotional discomfort. This is because their thinking patterns are unconsciously influenced by heuristics and cognitive biases.

Harley Hahn

“Heuristics” are mental shortcuts that underlie our decision-making processes. We use heuristics many times a day to help us make good decisions quickly, often with minimal information. However, when we apply heuristics to the stock market — which is much different from everyday life — they often lead us astray.

“Cognitive biases” are powerful patterns of thinking, mostly irrational, that tend to always lead us astray.

So far, we have discussed seven different heuristics and cognitive biases:

1. False Analogies to the Physical World

Interpreting investment information, such as graphs, as if they were describing phenomena in the physical world. This leads us to assume that stock prices act as if they are following the laws of gravity and inertia.

2. Representation Bias

Assuming that similar circumstances will lead to similar outcomes. This leads us to assume that the past can predict the future.

3. Loss Aversion

Experiencing more satisfaction from avoiding a loss than from acquiring a similar gain. This leads us to make decisions because of the fear that we will suffer emotionally if we sustain a loss.

4. Endowment Effect

Placing a higher value on something we own, compared to how we would value it if we didn’t own it. This makes it difficult for us to sell our holdings, even when it is in our best interests to do so.

5. Disposition Effect

Waiting too long to take losses or to moving too quickly to realize gains. Over time, this causes us to increase our losses and decrease our gains.

6. Sunk-cost Effect

Refusing to acknowledge that money that can never be recovered is gone forever. This makes it difficult to abandon a misguided plan, when we have already spent money on it.

7. Anchoring

Relying on only one specific item of information (an anchor) when making a decision, for example, the price that we paid to acquire a stock. Anchoring makes it difficult to analyze a situation logically, independent of previous costs or gains.

Is this column, we will discuss three more related ideas:

8. Confirmation Bias

9. Cognitive Dissonance

10. Bounded Rationality

Confirmation Bias : Have you ever noticed that people tend to remember and interpret information in a way that confirms what they already believe? This is a very important cognitive bias known by several names, most commonly, “confirmation bias.”

The most important characteristic of confirmation bias is that — as odd as it sounds — the stronger the belief, the stronger the bias. This is why, in public discourse, the most highly charged topics (for example, gun control, abortion, global warming) stimulate the most biased opinions and actions.

Why does confirmation bias exist? It is not the case that human beings are biased towards confirming what they already believe, because they are unwilling to look at any evidence to the contrary. The actual explanation answer is more subtle.

The truth is, most people are willing to listen to opinions different from their own. (This is why there are so many arguments.) However, during such arguments, people tend to listen in a one-sided way, focusing only on the evidence that supports their point of view, while ignoring alternatives that might prove them wrong. Thus, confirmation bias is caused, not by ignorance, but by poor listening skills.

Confirmation bias is so common and so powerful that, as in investor, it can severely limit your ability to make independent, rational decisions. As such, you must come to terms with it. Specifically, you should train yourself to recognize confirmation bias in your thinking and — once you recognize it — to force yourself to consider alternatives.

The easiest way to overcome confirmation bias is to deliberately seek out opinions and information that differ from what you want to hear. In practice, there are two good ways to do this.

First, before you make any important financial decision, find a strong-willed, knowledgeable person who is willing to listen to your ideas and argue against you.

Alternatively, if you have enough maturity, you can force yourself to be a devil’s advocate and do your best to pick apart your own opinions, trying to see if you can prove yourself wrong.

As an example, let’s say you have done a lot of research and have identified a stock you think is undervalued. The stock, you believe, has a good chance of going up over the next few years. Before you invest, see if you can find a smart, knowledgeable person who likes to argue. Present your findings to him or her, set aside your ego, and invite that person to point out your mistakes. (This, in a nutshell, is what scientists must do before their ideas will be accepted by other scientists.)

There is no doubt that arguing with such a person can be frustrating. Moreover, if he or she succeeds in finding significant flaws in your research or your reasoning, you will probably feel foolish and embarrassed. However, feeling foolish and embarrassed is a lot more pleasant than what you will feel if you lose a lot of money, because a bias you didn’t even know you had kept you from thinking well.

Harley’s Rule of Investing #8: The market doesn’t care what you believe.

Cognitive Dissonance: It is a fundamental characteristic of human beings that we are able to hold two conflicting ideas in our mind at the same time. For example, we can both like and dislike a particular person; we can both support and not support a specific social cause. The ability to maintain contradictions in our thinking creates a valuable mental richness that would not be possible if we were able to see the world only in discrete, black-and-white terms.

However, when we find ourselves under the influence of contradictory ideas that relate to our beliefs or our desires, we experience significant mental discomfort. The psychological term for this discomfort is “cognitive dissonance.”

Cognitive dissonance is most pronounced when our actions do not match our beliefs. For instance, consider an overweight person who wants to lose weight, and who believes it is unhealthy to indulge in refined carbohydrates and sugar. From time to time, he may, nevertheless, find himself chowing down on pizza and chocolate cake. In such cases, something inside him will need to change in order to relieve the unpleasant feeling produced by the harsh inconsistency (the dissonance) between his actions and his beliefs.

In this case, the person will most likely modify his thinking, at least temporarily, to make himself feel better. He might, for example, justify his indulgence by telling himself that eating pizza and cake is a treat, and everyone deserves a treat once in a while.

Rationalizations like this usually serve their purpose, in that they reduce the internal discomfort created by the cognitive dissonance. However, in the long run, such strategies are merely temporary solutions to a permanent problem. As such, they cause more harm than good.

When we invest, it is common to encounter significant cognitive dissonance in the form of misgivings. Most often this happens after we have made an important decision and, later, we encounter information that leads us to think that our decision may not work out as well as we had hoped.

In such cases, we must resist the temptation to reduce our discomfort by ignoring or discrediting the new information. Instead, we are better served by asking ourselves if we ought to reevaluate our decision. If so, we must do so dispassionately, without bias.

Harley’s Rule of Investing #9: It is a lot easier to be honest with other people than it is to be honest with yourself.

Bounded Rationality: To invest well requires us to predict the future. Strictly speaking, this is impossible because the stock market is inherently unpredictable. Nevertheless, over the long run, it is possible to make money, if we can fulfill all of the following requirements:

1. We must know what we are doing.

2. We must make good decisions.

3. We must think rationally.

4. We must be lucky.

As straightforward as this seems, it is difficult to do, because of natural limitations beyond our control, a concept economists refer to as “bounded rationality.”

Bounded rationality asserts that our potential to make the best possible decisions is limited in three important ways:

First, we are limited by the amount of information that is available to us. No matter how much knowledge we are able to acquire and understand, our information will always be incomplete.

Second, we are limited by our ability to think well. No matter how smart we may be, and no matter how logical we try to be, we are still creatures of habit, emotion, and intuition. As such, we are susceptible to the problems created by the heuristics and cognitive biases. Thus, it is impossible for a human being to think comprehensively and rationally under all circumstances.

Finally, we are limited in that every decision we are called upon to make must be carried out in a finite amount of time.

Because of the limitations imposed by bounded rationality, there is a pattern of action that will tempt you – a trap I want to make sure you avoid.

When you are faced with a complex and difficult situation, it is common to feel uncomfortable. This is normal. It is a warning that you do not have the information, the expertise, and the time to make an optimal decision.

What many people do in such circumstances is to over-simplify the issues to the point where they can make a decision, even if it doesn’t make sense. To do so, they will manipulate themselves and the people around them, unconsciously, so as to simplify the details and the possible choices they are facing. It is only then — after they have fooled themselves into thinking the situation is easy to understand — that they begin to apply logical thinking (with predictably negative results).

As an example, it is common for companies that receive many applications for a job to use arbitrary criteria to narrow the field. For instance, a company with 200 applications for a single job might consider only those people whose resumes were no more than one page long. Although this is not a particularly good strategy, it does reduce the applicant pool quickly, making the job-hiring process a lot easier.

Consider another example. An investor has a portfolio consisting of several hundred shares in each of 10 different stocks. He needs to sell some of the shares within the next week to pay his son’s college tuition. Trying to figure out which stocks to sell, and how much, quickly overwhelms him. There is simply too much information for him to analyze in a week.

However, a friend with business experience happens to mention that, in his experience, young CEOs often have trouble growing a company past a certain size. The investor checks each of the 10 companies and finds that three of them have CEOs younger than 50 years old. He then looks only at those three companies, focusing on which of the three stocks is the best one to sell.

Being human, we will never escape the limits of bounded rationality. As a result, we must accept the idea that we will often be called upon to make investment decisions we can’t fully understand. Nevertheless, in such situations, we must avoid the temptation to make decisions foolishly, just because doing so is easy.

There are no simple solutions to the problems caused by bounded rationality. The best advice I can give you is to simplify only in a way that makes sense — and then respect your limitations.